the product development manager

Michael, the product development manager for Square Pharmaceuticals (SP), joined the firm about seven years ago. With a bachelor’s degree in chemistry and a Master…

Michael,
the product development manager for Square Pharmaceuticals (SP),
joined the firm about seven years ago. With a bachelor’s degree in
chemistry and a Master of Applied Finance from Kaplan Professional,
Michael has been fairly successful in his professional career. Prior
to working at SP, Michael was responsible for the launching of three
highly successful drugs at another mid-sized pharmaceutical company.
It did not take long for the head-hunters to find him and, shortly
thereafter, SP made him an offer that was too good to refuse. SP is a
fairly large pharmaceutical company that has a number of patented
drugs under its belt. With a number of the firm’s patents expiring
in the next three years, there has been some pressure to expand its
production lines. Michael has been asked to make recommendations to
the board for new investments, specifically regarding a new drug
recently developed by SP’s research department.

The
Vision Research division of SP recently invented a new drug,
nicknamed ClearView, for the cure of myopia, which has shown
tremendous promise in the preliminary test. The project leader,
Catherine, is very confident that this new drug could revolutionise
the world of ophthalmology and has prepared some standard investment
estimates if the product is approved and launched early this year.

Development:
$26 million

Testing:
$12 million

Initial
marketing: $18 million

Total
investment: $56 million

The
new drug is expected to be a blockbuster that will help to increase
the company’s market share and the sales are expected to be $20
million in the first year. The sales revenue generated from this
product alone is expected to grow at a rate of 11% p.a. in the first
three years and stay in line with inflation thereafter until its
patent expires in 10 years.

Required
equipment costing $6 million is expected to have a useful life of 10
years. After 10 years it is expected to have a salvage value of
$300,000, although it will be fully written off for tax purposes
during the period of its useful life. Fixed costs are estimated to be
$3.55 million per year and remain constant for the life of the patent
while variable production costs are expected to be equal to 20% of
sales revenue in each year. To get the project underway, additional
inventory of $550,000 would be required. The company would also need
to initially increase its accounts payable by $110,000 and its
accounts receivable by $200,000. Catherine estimates that the net
working capital requirement for the product would be maintained at
20% of its sales each year thereafter.

The
weighted average cost of capital is calculated to be 12.5%. The
current inflation of 1.5% p.a. is expected to remain stable over the
next 15 years, and so is the company’s tax rate of 30%.

(a)
You have been asked to advise the board whether the proposal should
be adopted using NPV and IRR analyses. The board has requested an
appraisal of cash flows relating to investment, operations and exit
(it is assumed that the product will cease production when the patent
expires in year 10). In doing so, you need to present the following
(using Excel):

(i)
treatment of depreciation .

(ii)
treatment of working capital

(iii)
calculation of initial cash outlay in year 0, operating cash flows
per year and exit cash flows in year 10

(iv)
calculation of NPV and IRR

(v)
investment recommendation based on NPV and IRR analyses. (b) You are
required to provide a sensitivity analysis using the model developed
in Q1(a) such that the findings can be scrutinised by the investment
committee. The sensitivity analysis should address movements in NPV
and IRR (with reference to the base case) arising from a plus/minus
20% variation in estimates for sales and for fixed costs. (using
Excel)
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